In a recent online conversation between two people concerned about the weakness in the market for U.S. Debt, they used the ratio of U.S. deficits to gross domestic product (GDP) as an indicator of the problem. I will save the topic of U.S. Debt for another day. In this article, I would like to discuss the validity of deficits-to-GDP as an economic indicator. I would apply the same questions to many other indicators frequently used by market commentators.

The Zen master reputedly admonished his students not to confuse the finger pointing at the moon with the moon itself. I suggest that many of the formulas used to support hypotheses about the market amount to an obsession with pointing fingers. They frequently forget to take a closer look at the moon itself.

Defining Relationships

I will use symbols to describe the relationships discussed in this article. This might look a little like math, but don’t worry; it’s not. I will use symbols to shorten descriptions, but no real math.

I will express the ratio of the Deficit (Def) to Gross Domestic Product (GDP) as :

Def/GDP.

Deficits

Deficits consist of the amount of government spending not paid for by taxes. I will express deficits as:

Def = G – T.

where

• Def=Deficits
• G=Government Spending
• T=Tax Collections

Gross Domestic Product (GDP)

Many economists use gross domestic product (GDP) as a measure of the productivity of an economy. GDP commonly gets expressed as:

GDP = C + G + I + NX

where

• C=Consumption;
• G=Government Spending;
• I=Investment; and
• NX=net exports

A Restatement

Expressing the ratio of deficits to GDP using their component parts exposes some interesting questions. I will restate:

Def/GDP

as

(G – T)/(C + G + I + NX)

Questions

When we look at the component parts of calculating the ratio of deficits-to-GDP, some interesting questions arise. The major questions deal with government spending and taxation.

Government Spending

Does having government spending in both the divisor and the dividend not cause a problem? Don’t the statisticians need to adjust this relationship? If, for example, government spending increases, does it not increase the deficit and GDP simultaneously?

This question leads to the next question.

Doesn’t taxation affect both sides of this relationship?

Taxation

To finance government spending through taxation, does that not reduce consumption, investment, and net exports? So, if the geniuses in Washington try to reduce the deficit-to-GDP ratio by raising taxes, that will reduce the deficit, but what effect will it have on GDP?

This might seem like the perfect solution for those who think the government spends money better than the citizens. For those who believe the “private sector” does a better job, raising taxes seems like a bad idea.

Conclusion

Since the two men engaged in this conversation are self-professed “Austrian Economists,” I suggest that they recall a fundamental principle of the Austrian methodology: “subjective value.” Put simply, the market for U.S. debt will dry up when investors prefer to put their money somewhere else, whether they believe in the deficit-to-GDP ratio or some other magical forecasting tool.

The main point I want to make in this article is that people should take care when choosing their forecasting tools. GDP by itself provides a perfect example.

As I pointed out above, the calculation has a feedback effect that seldom gets recognized. For government spending to increase consumption, investment and exports must decrease. The government cannot increase total output by increasing its “spending,” as the linear formula would suggest.

GDP contains what I have often referred to as an “error of aggregation.” The U.S. economy does not consist of a monolith. It does not increase or decrease as a single unit. It consists of many different products in many different locations.

Be careful of the statistics you cite when discussing market behavior.